Target vs existing capital structure

CFA Level II
#1

I came across a few calculations in equity valuation where to calculate WACC, they used target D/E ratio instead of the existing one.

That’s bizzare! Aren’t valuations based on the company’s current setup? I don’t understand the point of discounting cashflows using a rate for a structure (target) which doesnt exist yet.

Thoughts?

PS: It makes more sense to use current D/E ratio coz if I (say) end up buying the company based on my valuation, then I can influence it’s target capital strucutre. In which case, use of the (old pre-acquisition) company’s target d/E would be worthless.

#2

As far as I remember when you are given current D/E and target D/E always use the target one. Be careful not to use the acquirer D/E ratio.

#3

Acquirer vs target is fine

What I mean specifically is whether to use target’s existing D/E or target’s D/E which they aim to achieve?

#4

I wasn’t clear enough - use the target’s target D/E.

#5

Yeap I know thats what we’re told to use but isn’t it counterintuitive? If I end up acquiring a firm, I can change its targetted capital structure - so really target’s target D/E is a bit meaningless if I’m going to be in a controlling posn

#6

I guess the assumption is that the cost of financing won’t change immediatelly only because you have acquired the target. So the optimal capital structure (the one that minimize WACC) would be unaffected before and after the acquisition. Both previous and current owners try to maximize wealth => optimal capital structure = target’s target one.

*I’m just speculating for the argument, in the real life most probably the target’s credit rating would change so the new optimal capital structure will be different from the initial one.